Financial Reform and American Politics
Outrage over the financial meltdown shouldn't be a left vs. right thing.

By Kevin Drum | Sun Apr. 18, 2010 4:24 PM PDT

Ryan Avent has a very good brief summary [1] of the state of play in financial regulatory reform today. It's worth a read. Bewarned, however: the conference that inspired the post, he says, "has left me with a sense of resigned cycnicism."

The whole subject has left me with considerably more than that. Brutal partisan brawling over things like healthcare reform and climate change legislation was (and is) entirely unsurprising. It was the same old fights as always, and it never really left me with a feeling that politics had broken down in any real way. Financial reform is different. Politically, the obvious play for both parties is to outbid each other in efforts to rein in Wall Street, which practically everyone in America hates. But even though this would be an enormous vote getter, neither party is doing it. Democrats are offering up some mild reforms that would modify the playing a field a bit but not really fundamentally change anything. Republicans won't even go that far. Apparently motivated by industry fealty and a desire to simply oppose anything Democrats offer up, they're unwilling to support even modest reforms.

It's hard to know what to think about this. If your city were nearly destroyed by a huge earthquake, proposing better building standards would be an obvious response. It wouldn't be a left vs. right thing, it would be a property developers vs. everyone else thing. The financial meltdown of 2008 was like that. It exposed such massive fault lines in our banking system that outrage really shouldn't be a left vs. right thing. It should be a big banks vs. everyone else thing. But the intellectual and monetary hold of Wall Street on our political class is so overwhelming that it was able to turn the whole affair into just another excuse for the usual partisan bickering. The winners, of course, will be the big banks.

Ryan, I think, lets everyone off the hook too easily by saying that one of the problems is that "no one can agree on the underlying causes of this latest crisis." That's not quite right. It's true that a lot of reasons for the crisis have been offered up. Here are the ones that occur to me just off the top of my head:

That's a lot of possible reasons. But that's not why we're stuck. Everyone agrees that skyrocketing leverage was a huge problem, for example. Everyone agrees that mortgage fraud was a problem. Everyone agrees that ratings agencies were a big problem. Ditto for resolution authority, risk models, OTC derivatives, and the instability of the repo funding model. So even if there's disagreement about some of the items on this list, there's enough agreement about the others that there should be no problem putting together a stringent bunch of new rules that take a pretty serious whack at Wall Street. After all, agreement on 70% of the big problems is actually more than you get most of the time.

But we're not getting any of this. Treasury wants to shove off leverage concerns to Basel. Ratings agencies are largely getting a pass. Mortgage fraud is getting a pass. Risk models seem beyond anyone's scope to regulate and the repo funding model, like leverage, is being punted to Basel. In the end, we might get a bit of action on resolution authority and derivatives regulation, but that's probably about it.

So, yeah: resigned cynicism. How can the entire world's financial system nearly blow up and leave practically no serious action in its wake? How can one party respond only with weak tea while the other party flatly refuses to accept even that? It boggles the mind. And yet, that's pretty much what's happened. Welcome to 21st century America.
Source URL: http://motherjones.com/kevin-drum/20...rican-politics

Apr 18th 2010, 21:11 by R.A. | WASHINGTON
I HAVE been meaning to summarise my thoughts on financial regulatory reform in the wake of the Hyman Minsky conference on same. I have to say, it has left me with a sense of resigned cycnicism. I'll get to details in a moment, but I think that the most important thing to understand about financial reform is that its dynamics are simply too complicated to lend themselves to good policy. As Paul Krugman said during his talk on Thursday, financial reform is totally different from health care reform. There the crises are clear—coverage and costs—and the policy positions were clearly defined and coherent. On financial reform, no one really agrees about anything. If you were to sit down a group of progressive economists and ask them about health care, they'd all say more or less the same thing. Ask them about financial reform, on the other hand, and you're likely to get wildly different answers. No one can agree on the underlying causes of this latest crisis, or on why the world managed to avoid crises in the postwar decades, or on what steps should be taken to make financial systems more secure. While I think there are good regulatory ideas out there, I'm increasingly of the opinion that if the bill that passes ends up being an effective change to the regulatory environment, it will mainly be by accident.

I've also found myself thinking that if financial sector growth is so good for the real economy it ought to be easier for its defenders to demonstrate this empirically. Sure, one can find financial innovations that seem helpful and posit how the general process of groth and innovation in finance could be good for growth, but the costs of a large financial sector are extremely apparent while even the most ardent backers of financial innovation have a difficult time explaining how economic performance would have been harmed by restrictions on financial activity. Obviously, finance has made a lot of people rich, but that's not the same thing as being good for growth on net. It shouldn't be that hard to tease out some evidence of truly positive effects, and yet no one is out there making a compelling quantitative case. That should probably tell us something.

On to more specific thoughts. The Federal Reserve is very unhappy with the prospect of losing its regulatory authority over all but the largest financial institutions. The four Fed officials to speak at the conference all made this extremely clear. The four regional Fed presidents were also quite strident in their advocation of an end to too-big-to-fail. Kansas City Fed president Thomas Hoenig, who spoke at the conference, has an op-ed in the New York Times outlining his thoughts, which were basically reflected by the other Fed presidents to attend. I found this all to be exasperating. None of the attending presidents adequately explained how a Fed that completely failed to prevent dangerous consolidation before the crisis should now be viewed as a credible enemy of too-big-to-fail after the crisis. None of the attending presidents provided tangible evidence of internal changes designed to make the Fed a more credible regulator. Each was asked about the odd disconnect between the Fed's pre-crisis actions and its post-crisis rhetoric, and each responded by saying little more than "we've learned our lesson, now trust us". And none of the attending presidents made a real case for why ending too-big-to-fail should be the cornerstone of reform and how it might be accomplished. The Fed should lead by example. If it believes it can regulate most effectively, it should be explicit about how it might do that. We're all good economists here. If the incentives were in place to turn a blind eye before, and little has changed, then "we've learned our lesson" will not make for a sustainable model of competent regulation.

Second, it does seem that there is agreement on smaller regulatory measures that are worth adopting, and these should be the focus of a regulatory bill. A central derivatives clearinghouse, for example, is a commonsense reform. Assuming that too-big-to-fail is irreparably baked into the system, moral hazard should be addressed through regular payments into an insurance or resolution fund; in other words, the government should try to make the banks pay ex ante for the bail-outs they're likely to receive. Clear resolution authority is also needed. It might not be used in a crisis period in which there is widespread insolvency, either from a common shock to banks or common bad behaviour by banks. It could and should be used at other times, and the occasional orderly winding up of a failed institution may well impart some market discipline on other large institutions. It's possible that a constituency could be built for more aggressive reform (though given the nature of the debate, as described in the first paragraph, I doubt it), but if that doesn't happen and the above changes are made, then the bill will be a good thing on net.

Third, I'm increasingly of the belief that the best thing that might come out of the crisis would be the use of public anger to change the culture of Wall Street. It's hard to see how the world would be a worse place if outlandish bonuses were met with vocal public scorn, or if the brazen pursuit of financial wealth were looked down upon, or if regulatory weakness in the face of Wall Street pressure were greeted with hooting derision. Greed can be good. Markets thrive on it. It has driven people to build better technologies and devise better supply chains and make better movies. On Wall Street, greed has driven firms to move their offices a few miles closer to an exchange so that their online trades can be executed nano-seconds faster than their competitors'. It has generated innovations in the construction of personal financial products so that fees can be better hidden. Markets work when the pursuit of self-interest generates societal benefits, which is why we generally praise the self-made man or woman. They've done well for themselves while doing well for the rest of the country. Wall Street should be held to the same standard. If financial executives are going to behave as parasites, they should be shamed as parasites. Maybe nothing will change as a result, and they'll comfort themselves by drying their tears with gold leaf. But maybe it will have an effect.

Next, Mr Krugman had another interesting thought that I've been musing on for a couple of days. He said he'd been having the uncomfortable feeling that the crisis-free years of the postwar period had little to do with any particular financial regulation and a lot to do with the franchise value of banks. The banking sector, at that time, was highly uncompetitive. The lack of competition made bankers fat, happy, and risk averse. When the banking sector was deregulated, banks had to work for their money. This led to some improvements in customer experience, but it also made bankers more aggressive in their pursuit of new profits (particularly as public ownership of large financial companies became more common). This increased the involvement of big banks in dangerous financial activities, which led to growth in systemic risks. This could put the administration's attitude toward breaking up the banks in a new context. An oligopoly of hugely profitable mega-banks seems both obscene and dangerous in light of the crisis, and yet the administration hasn't really thrown its weight behind a plan to chop up the biggest banks. It's possible that some have concluded that since any such plan would be a political impossibility, the best thing to do is to try and recruit the big banks to the side of stability—to put them in a situation where they will support restrictions on certain activities so long as their status as cash-printing money machines seems safe. I don't know if that's right, but it's an intriguing argument.

Finally, several of the conference's speakers made the point that regulators had about 90% of the tools they needed to prevent a serious crisis before the crisis hit. They just didn't use them. A lack of needed tools is a convenient excuse for everyone who failed to do their job before the crash, which is everyone, and so you see the reform debate focusing on which new rules or institutions or regulators or authorities are needed that weren't previously around. In some cases, the new tools argument makes sense, but most of the time the real problem was that the people in charge were unwilling to do their jobs. To generate different results moving forward, what's needed isn't new councils or abilities, but new incentives and better oversight. Incentives and oversight could be changed via legislation, but they don't have to be. Cultural shifts, or a press given less to financial cheerleading could make a meaningful difference.

So those are my thoughts. As financial reform proceeds, it's always worth asking whether the changes in the law would have prevented the crisis or reduced its severity. At this point, I'm not sure the conversation in Washington is really focused on that question.

This is really a case of overlapping hypocrisies. Take the housing bubble as an example. At the very end-user level, homeowners decided (whether on their own, or under the heavy influence of big banks, or a little of both) that homes were no longer simply places to live, but investment tools. In essence, homeowners were really just playing the same sort of games that big bankers were, but on a simpler level.

Add in a factor like mutual funds, which a TON of homeowners are/were invested in, usually as part of a 401k or IRA or something, and you have people serving two Gods in that, on one hand, everyday ham-n-eggers want to rip up corporations for their supposed greed, and politicians for being beholden TO those corporations, but, at the same time, they were also benefiting from rapidly expanding portfolios worth more and more money. So, the bubble helped everyone make money, then hurt the end users by stripping away the value of their homes and stocks.

Now everyone wants tight regulations and to tear into the banks....but, at the same time, this will also hurt those stock portfolios again. It can't really be both ways. Everyday "main steeters" want to act like big bankers themselves, but when it all falls apart, they then want to destroy those people without recognizing the far-reaching implications of their own investments WITH and through these big banks. So the third way is to just trust a virtually "un-trustable" government.

The worst part of it is, this is more complicated than a watch, and most people only can see as deep as the face of it. In this case, even the watch-makers themselves have difficulty understanding how to repair the watch.

The bottom line is that the politicians are far too beholden to the big banks to actually DO anything about this, so it's bound to just happen again...and, when it does, the average citizen will play right along again...

NEW YORK: In a 1964 concurring opinion deciding Jacobellis v. Ohio, Associate Supreme Court Justice Potter Stewart wrote about ''hard-core pornography'' and his struggle to define it: ''Perhaps I could never succeed in intelligibly doing so. But I know it when I see it.''

Using Potter's indisputable logic, it's hard not to see something obscene in how Wall Street reaped massive profits and bonuses in 2009 — and continues to do so, as is clear from Monday's announcement by Citigroup that it had earned $4.4 billion in the first quarter of 2010, which was even more than earned by Bank of America ($3.2 billion) and JPMorgan Chase ($3.3 billion) in the same period — merely 18 months after trillions of dollars of American taxpayers' treasure was used to save a financial system brought to the precipice by Wall Street's greed and irresponsible risk-taking. Goldman Sachs, which is facing a civil fraud suit filed by Washington regulators, reported robust earnings Tuesday morning as well.

How did this happen at the same time Main Street continues to suffer from an unemployment rate of almost 10 percent and from the worst recession in generations? Partly, this resulted from the original strategy of the Treasury and the Federal Reserve to first fix the banking system and then worry about repairing the wider economy. Hence, the $700 billion Troubled Asset Relief Program arrived in September 2008, followed by, in February 2009, the $787 billion stimulus program, or American Recovery and Reinvestment Act.

The benefits for Wall Street started with the extensive de-leveraging that continues the world over in the wake of the financial crisis (it caused) by helping companies raise new equity and refinance existing debt.

The Wall Street firms that survived the crisis reap billions of dollars in fees for this sort of work. Mostly, though, Wall Street is making money by taking advantage of its rock-bottom cost of capital, provided courtesy of the Federal Reserve — now that the big Wall Street firms are all bank holding companies — and then turning around and lending it at much higher rates.

The easiest and most profitable risk-adjusted trade available for the banks is to borrow billions from the Fed — at a cost of around half a percentage point — and then to lend the money back to the U.S. Treasury at yields of around 3 percent, or higher, a moment later. The imbedded profit — of some 2.5 percentage points — is an outright and ongoing gift from American taxpayers to Wall Street.

You're welcome.

And now for the truly obscene part. By keeping interest rates so stubbornly low — and by remaining committed to doing so — the Fed is crushing the rest of us, especially senior citizens on fixed incomes and those who have rediscovered saving in order to have some peace of mind.

In an essay in The Wall Street Journal recently, Charles Schwab pointed out that there is more than $7.5 trillion in American household wealth stored in short-term, interest-bearing checking, savings and CD accounts. (The average interest rate for a one-year CD is 1.3 percent.)

Our savings is another source of virtually free capital for banks to use to lend out at much higher rates. These anemic yields are a ''potential disaster striking at core American principles of self-reliance, individual responsibility and fairness,'' Schwab observed correctly.

Sure seems to be working for Wall Street, though. At $140 billion in compensation and benefits, the 2009 paychecks on Wall Street were the best ever. While several top executives named in public filings may have tried to minimize their 2009 compensation after so much populist rage, they could only take this charade so far.

Hedge-fund managers did even better. The top 25 earned a total of $25.3 billion in 2009 — an average of $1 billion each — with the lowest paid hedge-fund manager receiving $350 million. Topping the list was David Tepper, of Appaloosa Management. He made $4 billion last year. ''We bet on the country's revival,'' Tepper said in an interview with The Times.

Let's be clear about one thing: The American people made a bigger bet on the country's revival than did Tepper. But we are still waiting for our payoff. Surely Justice Stewart could see that the tax on American savers and the corresponding subsidy to hedge-fund managers, bankers and traders is nothing less than hard-core pornography.

Cohan is a columnist for nytimes.com. He is the author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street and a forthcoming book on Goldman Sachs.